With economy on recovery curve, RBI begins squeezing out money

On Friday, the Reserve Bank of India’s Monetary Policy Committee (MPC) kept policy rates and stance unchanged but the key takeaway was liquidity normalisation. That’s because the MPC’s job ends with policy rate decisions, but the central bank’s task begins soon after. Liquidity management is the operating procedure of monetary policy, and ensuring adequate liquidity – neither deficit nor surplus – is critical.

Currently, we have surplus liquidity of Rs 12-13 lakh crore with nowhere to go. For now, RBI is absorbing Rs 4-6 lakh crore paying interest to banks in overnight, weekly and fortnight windows. The key here is the interest rate. Usually, banks park surplus funds with RBI at fixed rate reverse repo, currently set at 3.35%.

But to encourage banks, RBI has begun variable rate reverse repo auctions, as overnight rates, or the short end rates, remained sticky due to liquidity glut. Following the 7- and 14-day auctions, rates are now closer to the operative policy rate of 3.35%. But RBI cannot go on paying banks, and system liquidity cannot remain in surplus forever.

The next step is to flushing out surpluses. With growth recovery, perhaps, Das hopes credit growth will pick up and given the festive season, demand for cash also goes up. This in turn will lower bank’s reliance on RBI to park their surpluses.

Crucially, RBI kept the room open even for a 28-day variable rate reverse repo auction, which if happens amounts to liquidity tightening. The central bank could also consider a reverse repo hike, though this shouldn’t be read as a step towards repo rate hikes. Markets were also looking for cues as to when RBI may signal raising the reverse repo rate, which will narrow the gap between the repo and reverse repo rate. In the ordinary course, the fixed rate reverse repo is usually set 25 bps below the policy repo rate. By this measure, reverse repo corridor is wider by at least 40 bps given that repo is held at 4%.